Digital Assets Strategy: Why Financial Institutions should consider including digital assets services
As discussed in our article around the current digital asset market opportunity, the rise of cryptocurrency as an asset class has brought increased attention from financial institutions, not only driven by the size of the opportunity, but also due to the presence of players aiming to benefit from the lack of specialized knowledge of traditional finance players in the emerging blockchain space.
The already present institutional adoption 81% of institutional investors surveyed by Fidelity viewed digital assets as having a role in investment portfolios, along with the expected final leap from large finance institutions to include cryptocurrencies in their service offering, has further encouraged institutions to consider the different cryptocurrency offering options and how that would affect their control over the whole financial value chain. According to Citi,74% of firms surveyed are exploring DLT and digital assets, and “DLT will be used not to experiment but to deliver” according to the survey. It is worth noting, the survey found that it’s not the technology that firms face issues with, but actually the people and the processes putting it in place.
Although digital assets’ services started as a need of differentiation, they are becoming a transformation lever for business growth, with increasing demand from different financial players. The 5x DeFi market capitalization increase between Aug 2020 and Aug 2023 (with up to x22 in Nov 2021), and the rise of new technologies around the blockchain ecosystem (NFTs, DAOs, Staking, Metaverse, etc.) suggest the industry is still far from plateauing, presenting plenty of room for growth and opportunity, for those willing to embrace it.
To maintain their fiduciary position, traditional financial institutions are approaching digital asset offering with the intention to continue as trusted partners when providing clients with a wide and renewed range of financial services. Digital asset management requirements will vary from firm to firm, however there are certain considerations every player in the industry should consider before embracing cryptocurrencies as part of their offering:
Technology & Operations Definition
When assessing different technological options, a non-intrusive integration approach with current applications is key, assessing both external solutions on how they can fit within the firm’s architecture, as well as internal capabilities on developing in-house solutions or leveraging existing applications or products that can help to accelerate the launch of these services. Hence, the design of a flexible modular architecture becomes vital to cater for future service offerings and to keep up with digital native players that can add new services in an agile way.
Strategy & Governance Model
Beyond the technological discussion, the operational model also plays a pivotal decision from a governance, strategic and legal standpoint. Three main options for this model have been identified: creating a NewCo, a Federated Market model and a Centralized model, with different degrees of dependency between the holding company and the entity providing digital asset services.
Business Development
As a first step, a market scan is necessary to identify all competitors within the target geography as well as current regulations that might limit the offering. This initial scan will help shape the kind of products and services that will be offered to target clients and these clients’ appetite for these new services. With this information, the creation of a business case that predicts profitability, as well as a necessary roadmap to ensure the feasibility of the service.
Regulation Considerations
Regulatory uncertainty is still a major issue for cryptocurrencies due to their conflicting interest with traditional securities laws, particularly in terms of how customer protection practices are sustained. Nevertheless, the European Securities and Markets Authority (ESMA) has introduced the MiCA regulation that entered into force in June 2023, aiming at reducing licensing requirements in the EU as well as introducing more obligations and disclosures for Crypto Asset Service Providers (CASPs) and token issuance processes, to protect users and investors.
Risks & Cybersecurity Concerns
- Cryptocurrency custody offers 3 different approaches according to cyber risk appetite:
- Self-custody: No third-party involved. The keys are stored in a vault property of the owner of the digital asset
- Partial custody: The custody relies on several parties that need to contribute with their part of the key when signing an operation.
- Third-Party custody: A third-party assumes the responsibility of storing the key and acts on behalf of its customer according to given instructions.
The institutionalization of the cryptocurrency industry and the first steps in regulation being taken, have given rise to discussions regarding the extent of the impact it can have on the financial industry. From there, a lot of considerations and products have emerged, setting the necessary basis for traditional institutions to develop their own solutions. Overall, this is just the beginning of how traditional finance will evolve to adapt to Web3 trends and the new opportunities they offer.
